Cap rate is merely the relationship of the income to the price. It only looks at one year and does not include any debt payments. Cap answers the question "if I pay X dollars for Y return (net operating income) what is my rate of return? The formula is NOI/Price=Cap rate. As you mentioned in your question they vary depending on the type of property and the location. Caps serve as a barometer for you to gage how one property compares in price, relative to its income, to another. Most generally there will be a "going" cap rate for a particular type of property in a particular area. A cap on a NNN fast food restaurant in Southern California might be 5.5% and 8% in Missouri. If the NOI was the same on both, the property in Missouri would be much cheaper for the same income relative to the one in California. Find out what the "going" cap rate is for the type of property is in the area you are looking. When you find something you like compare the cap you will be getting to the comparables to see how it measures up. Use cap as a comparison tool but beware many times the cap rate is misstated by listing agents and sellers. To really see how a property performs over time, and to compare one property to another, you should take into consideration other factors like variable cash flows over multiple years, debt (remember cap is calculated as if you paid cash on only for one year), market cycles, etc. That calculation is internal rate of return (IRR). IRR will look at as many years as you want to look at and project how much you will make on every dollar you have invested, for every year it is invested, expressed as a percentage. It is not uncommon for a cap rate to be 8% yet the IRR to be over 10%. Much will depend on the vairables that cap doesn't consider. From there you can calculate capital accumulation which will tell you how much money you have made over the course of time with the investment. IRR is the percentage Cap Accum is the dollars. email@example.com or 800 554-7362 for more info.
Jun 23, 2009